Will J.C. Penney Find Its Feet in 2013?

After a disastrous 2012 performance, J.C. Penney is in big trouble. More and more shoppers are avoiding J.C. Penney stores these days, and management needs to reverse that trend quickly. J.C. Penney recently reintroduced discounts and coupons in an attempt to bring old customers back, but the early sales data is not encouraging. In fact, the company posted its worst performance of 2012 in the holiday quarter, despite running several promotions and sales. This news all bodes ill for J.C. Penney in 2013.

A disappointing yearIn early 2012, CEO Ron Johnson's team laid out a plan to "transform" J.C. Penney for long-term success while also improving profit in the near term. The company got rid of most sales and coupons in favor of an "everyday low price" scheme, while working to bring in new brands that would be showcased in individual "shops" within J.C. Penney stores. Among the first shops to be introduced were an Izod store and a Levi's denim bar.

A Levi's Denim Bar at J.C. Penney, courtesy of J.C. Penney.

Many of these shops -- including the Izod and Levi's shops -- have been quite successful since they made their debut last summer. But then it's not surprising that clothing sells better when it's presented in a fashionable and appealing way.

On the other hand, the company's decision to do away with coupons and discounts alienated many longtime J.C. Penney customers who loved bargain-hunting. Moreover, the focus on a few shops left other vendors out in the cold. In other words, sales of Levi's may have increased, but sales of Lee jeans plummeted at the same time.

J.C. Penney's management expected the new "no-discounts" policy to cause some revenue losses, but executives believed that strong sales in the "shops" would offset much of the lost revenue elsewhere. Executives also planned to improve gross margin while cutting operating expenses by $900 million over the course of two years, thus leading to higher profits in 2012 and beyond. On the cost side of the ledger, J.C. Penney performed more or less as expected; the company achieved expense savings of more than $600 million last year, putting the company on track to reach $900 million in savings for 2013.

However, customer outrage was far worse than J.C. Penney executives expected, leading to a 25% revenue drop. Meanwhile, a heavy reliance on clearances to sell merchandise damaged margins. The result: J.C. Penney lost more than $1.5 billion before taxes last year, thereby falling short of management's initial earnings target by a whopping $2 billion.

No solution?It's bad enough that so many customers deserted J.C. Penney last year, leading to the big loss. However, it's even more troubling that none of the company's attempts to fix things worked. For the first half of the year, J.C. Penney's sales dropped by 21.3%, a result that CEO Ron Johnson called "softer than anticipated." However, many investors expected the late summer launch of the "shops" featuring Levi's, Izod, Liz Claiborne, and other major brands to revive sales. Instead, J.C. Penney took a turn for the worse: Revenue declined 26.6% in the following quarter. While many of the shops have done well individually, they have apparently achieved their sales gains at the expense of the rest of the store.

Then the company reintroduced various promotions to try to bring customers back to the stores. J.C. Penney offered free children's haircuts during the back-to-school season, held a big Black Friday sale and a friends-and-family event during the holiday season, and offered customers "free gifts" (essentially $10 coupons) on more than one occasion. These tactics also failed: The company's Q4 performance was the worst of the year, with revenue down more than 28%. By the end of 2012, revenue was down nearly 35% from J.C. Penney's peak.

Thus far, opening popular brand shops within J.C. Penney stores and reintroducing discounts have not brought J.C. Penney out of its nosedive. That's why I think the planned reintroduction of regular sales events in 2013 may not bring back profits at J.C. Penney.

Transformation on hold?J.C. Penney has been running through cash at an alarming rate recently. While the company ended 2012 with nearly $1 billion in the bank, it had negative free cash flow of roughly $1.3 billion in the first nine months of 2012. In other words, at last year's rate, J.C. Penney could run out of cash by this fall. To save money, J.C. Penney may be forced to slow or stop the rollout of new brand shops before then. Building out dozens of shops in each of J.C. Penney's 700 largest stores obviously requires a significant upfront investment. Indeed, the company's CFO suggested last fall that the company will stop opening new shops if it's short of cash.

However, that would leave the stores stuck in limbo, with about 30% of the floor broken up into shops, and the rest in a traditional department-store format. A mixed layout like that would probably be confusing to customers, which could further alienate them from the J.C. Penney brand. J.C. Penney thus faces a Catch-22: It needs to be profitable to pay for the continued rollout of new shops, but it needs to complete the shops' rollout to present a clear message to consumers and thereby return to profitability.

ConclusionManagement is unlikely to escape from this dilemma. J.C. Penney is opening several new shops this month, in the hope that (along with a return to discounting) it will be enough to reignite sales growth. Given that similar moves in 2012 failed to bring customers back, this plan does not inspire much confidence. This is shaping up to be another rough year for J.C. Penney.

Learn moreJ.C. Penney has been a train wreck whose comeback always seems just around the next earnings corner, but investors are beginning to doubt that CEO Ron Johnson can weave the same magic that he did at Apple. If you're wondering whether J.C. Penney can survive its transformation, you're invited to claim a copy of The Motley Fool's must-read report on the company. Learn everything you need to know about Penney's turnaround, or lack thereof. Simply click here now for instant access.